Treasury Committee: Press Notice

Warnings of potential problems ahead should be beefed up to ensure that participants in the financial markets receive a clear message about the risks they are taking, the Treasury Committee states in a report today (March 3).

The report,
Financial Stability and Transparency, concludes that the framework by which the public authorities issue warnings of potential problems in financial markets is deficient and recommends that in future the Bank of England and the FSA should clearly highlight the two or three most important risks in a short covering letter to financial institutions, for discussion at Board level. The Bank and FSA should also seek confirmation from those institutions that these warnings have been properly considered and publish commentaries on the responses received.

John McFall, Chairman of the Committee, commented;

“It is clear that many market participants failed to heed warnings about a serious under-pricing of risk and the potential for impaired liquidity in financial markets in the mistaken belief that the good times would go on and on. The Bank and FSA can no longer hedge their bets, throwing potential risks out into the ether and then washing their hands of the consequences. We must ensure that in the future such warnings are heeded and acted upon by those at the top of financial institutions.”

The causes of the market turbulence of August 2007 onwards

The Committee investigated the underlying causes of the unfolding turbulence which has gripped financial markets since mid-2007. The Committee concluded that the benign macro-economic and low interest rate environment of the last few years spawned the growth of complex new financial instruments as well as new types of institutional investors. The search for yield in this environment encouraged many investors to invest in products which, it emerged, they did not always fully understand. Complex products have introduced increased opacity into the financial system, as is demonstrated by continuing uncertainty over the scale and distribution of losses in the banking sector resulting from exposure to sub-prime mortgages.

John McFall said:

“The ‘best and the brightest’ at our top investment banks have expended great energy designing ludicrously complex financial products, which you need a Nobel Prize in physics to understand. Whilst financial innovation and securitisation have brought real benefits and allowed for risk dispersion through the system, it has come at a cost. Product complexity has introduced increased opacity into our financial system, making it almost impossible to determine where risk lies and making it much more difficult to achieve financial stability.”

Investors

The report expresses concern that some investors did not exercise sufficient due diligence on the products they bought and appear to have been overly-reliant on the credit rating agencies, often using ratings as a “green light” to invest. The Committee therefore calls on investors to exercise greater responsibility for the decisions they make in the future.

John McFall said:

“It is clear that many investors threw caution to the wind when making investment decisions and were seduced into investing in products they did not understand by the alluring prospect of high returns. Many investors were blind to the risks involved, equated complexity with security and were engaged in a bout of collective madness. Unfortunately you cannot regulate against stupidity.”

The credit rating agencies

The report concludes that the problems affecting financial markets since early August 2007 have highlighted inherent and multiple conflicts of interest in the credit rating agencies’ business model, as well as flaws in their rating methods. The Committee calls for the credit rating agencies to tackle these perceived conflicts of interest as a matter of urgency if they are to regain trust and confidence.

John McFall said:

“The rating agencies have not emerged from the current episode of market turbulence smelling of roses. We need to have a serious debate about a root and branch reform of their business model to tackle perceived ‘conflicts of interest.’ If the rating agencies procrastinate on reform then we will have to seriously consider whether new regulation is necessary.”

The Committee’s overall approach and future work

The Committee states that detailed regulation of products is one response to the problem of product complexity, although not one that the Committee instinctively favours. However, the Committee warns that if the market and, in particular, the investment banks prove unable to address the problem of overly complex products, then regulation will need to be examined in the future.

John McFall said:

“This is not the end of the story. Today’s report merely marks the first phase of our work on financial stability and transparency. The consequences of the market turbulence of mid-2007 onwards go far beyond the financial community and there are growing signs that the credit crunch is now affecting the person on the street. We must act to ensure that in future problems in financial markets do not spill over and affect innocent bystanders. Our ongoing work on financial stability and transparency will address how we can better insulate people from the mistakes of big finance.

We will be examining whether the Bank of England and the FSA have raised their game and are sharpening their analysis of key risks in the financial system. We will also investigate whether incentive structures within individual financial institutions act to enhance rather than mitigate risk”